COVER STORY: A program for Australia's future

Regardless of the federal election outcome, Australia needs policies for industry and finance to handle the risks posed by the ongoing global financial crisis and from Australia's "two-speed" economy.

Failure to confront these problems today, while it can still reap the benefits of the mining boom, risks Australia, in a fit of absent-mindedness, being drawn into the orbit of China and, ultimately, compromising its sovereignty.

Following the global strategic and economic transformations underway, the world will be a vastly different place. However, Australia has been lucky to have been largely insulated from the global financial crises of the past two decades, and Australian politicians on both sides of politics have contrived to ignore the matrix of new economic and strategic issues that will increasingly threaten Australia's independence in the future.

Some solutions have been offered. For example, leading financial economist Saul Eslake has proposed that Australia should develop a substantial sovereign wealth fund to invest some of the proceeds of the mining boom for the future development of the nation after the mining boom is over.

Last year, six leading economists called for the establishment of a new "publicly-owned entity", akin to a people's bank or a development bank, to provide Australians a secure alternative to the commercial banks.

Such policies are needed now to deal with emerging economic and strategic issues that will become more and more difficult to resolve in the medium-to-long term.

Australia's two-speed economy

The mining boom has been of enormous benefit to the economy and our standard of living. However, it carries a "dark side", warns Alan Mitchell, economics commentator for the Australian Financial Review. (May 13, 2010).

He says that major manufacturing industries like Australia's car-markers (to which one can add agriculture) are being put under real pressure as the "high-speed" mining boom pushes up the value of the Australian dollar. This makes the less profitable manufacturing and farm products sectors more expensive and less competitive overseas and with imports.

He warns that these industries could be "wiped out" and "will not be easily replaced when the commodity prices and the terms of trade return to normal".

He says, "The hole left in the economy will be greater if the industries that have fallen victim to the boom provide important positive spillovers to the rest of the economy through their research and development and innovation."

The conflicts from a two-speed economy represent a major "market failure", famously called the "Gregory effect" or "the Dutch disease".

Named after Australian economist Professor Bob Gregory, the "Gregory effect" refers to a situation where an export boom, fuelled for example by a strong demand for resources, causes an appreciation in the exchange rate. This appreciation makes imports cheaper and exports dearer. The knock-on effect is to hurt the competitiveness of the non-mining sectors of the economy, which, in Australia's case, include manufacturing and agriculture.

Alan Mitchell also warns that, as Australian industries lose their competitiveness because of the soaring value of the dollar, a heavier reliance on manufactures (and food) imports will widen the current account deficit, continually adding to Australia's massive net foreign debt.

We are reaping a windfall from the boom in our mineral exports; but instead of using it to help repay our debts and save for the future, we are consuming imported goods at an even faster rate - goods that we are no longer prepared to produce at home. Furthermore, we are paying increased interest on the nation's external debt and dividends to foreign investors.

This means that Australia's debt to the rest of the world keeps growing, and Australia's banks have to keep borrowing overseas to pay the interest on these debts and to roll the debts over periodically.

Mitchell asks: "What if the resources boom proves to be unexpectedly short-lived?" This could occur because the record high price for minerals has driven massive investments in developing new mineral and energy projects worldwide. If supply rapidly catches up with and surpasses demand, then mineral prices will fall. When the mining boom is over, the hole left in manufacturing and faming will leave Australia without the ability to pay for imports or to pay off its net foreign debt.

Governments have been notoriously bad at predicting the length of mining booms. In the early 1980s, federal governments anticipated that Australia would ride on the back of a long mining boom that proved far shorter than expected.

Australia's immediate problem is the mixed blessing of a two-speed economy - the boom in the mining sector creating conditions that cripple manufacturing and agriculture.

The medium-term problem is the hole this makes in the non-mining sector. The decline in agriculture and manufacturing will deprive Australia of the capacity to pay for the nation's increasing dependence on imported manufactured goods and food, and to pay off the foreign debt and government debt once the mining boom subsides. The longer the boom continues, the deeper the crisis is likely to become.

This scenario will have serious strategic implications. It could very well leave Australia economically depending on China at the same time as China becomes the dominant regional power, and in the longer term, the aspiring world power.

Australia's economic issues must be addressed now, before events evolve to a stage where they cannot be resolved, thus seriously compromising Australia's economic sovereignty.

Global power shift

The world is undergoing a global strategic power shift of titanic proportions. It's being driven by the rapid rise of the Chinese economy, which by 2040 could reach US$123 trillion, or nearly three times the total world output in the year 2000, according to Robert Fogel, a Nobel prize-winning US economist and economic historian. China's rapid rise is on the back of a population of almost 1.3 billion.

Writing in Foreign Policy (January/February 2010), Fogel says that in 30 years China could be 40 per cent of the world economy, compared to the US (14 per cent) and the European Union (5 per cent).

He says that many economists have underestimated the likely growth of China. They have failed take into account "the enormous investment China is making in education".

Just as Western European college enrolment rates climbed by between 25 to 50 per cent in the last two decades of the 20th century, so China is capable of as dramatic an increase in education levels. US data indicate that a college-educated worker is three times as productive as a worker with less than a ninth-grade education; a high school graduate is 1.8 times as productive.

Fogel estimates that, in the lifetime of China's next generation, the country's high school enrolment rates could reach close to 100 per cent and college rates to about 50 per cent.

Also, Chinese labour productivity in the rural sector since 1978 has grown each year by approximately 6 per cent, accounting for one-third of China's growth. About 55 per cent of Chinese people (about 700 million) still live in the countryside.

Fogel says that Chinese data may well underestimate the economic output in the service sector. Meanwhile, Beijing has a host of policies that now aim to satisfy Chinese consumers' appetite for consumer goods by shifting economic output from being so export-oriented to supplying its own huge domestic market.

China and America "strategic competitors"

US economic power has enabled it to be also the dominant strategic power since World War II, the promoter and defender of democracy, human rights and the capitalist system, as well as provider of Australia's strategic umbrella.

The relative decline of America and rise of China make the two nations "strategic competitors" in the fastest growing region of the world economy, explains Dr John Lee, in a paper entitled The Fantasy of Taming China's Rise, recently published by Australia's Centre for Independent Studies (and summarised by the author in the Australian Financial Review, May 14, 2010).

While the US helped to make Japan "economically powerful and politically cooperative", it also kept it "strategically dormant and militarily inhibited".

This policy may have worked with Japan, but Washington is yet to admit that it won't work with China. The Beijing government has different ambitions. With its vast population and an economy growing much faster than that of the US, China's leaders intend to assert their nation's historical role as the dominant power in the region, and well beyond.

Dr Lee disputes Washington's assumption that further economic liberalisation in China will bring prosperity, followed by respect for multi-party democracy and human rights, as happened in other countries in the region.

Rather, he argues that the "modern Chinese model places far more power and wealth in the hands of the state sector than occurred in Japan or South Korea".

He writes: "State-owned champions are nurtured to dominate domestic markets at the expense of the Chinese private sector in order to prevent the rise of an independently-minded middle class. Getting ahead means working with the party rather than independently of it. Economic, much less political, liberalisation is hardly the [Chinese Communist Party's] intended end-game."

Beijing's authoritarian rule leads it to closely ally China with countries like North Korea, Burma and Iran, all of them enemies of the United States.

Beijing's association with the world's most oppressive regimes, its violation of human rights and refusal to respect basic market principles (private property, open markets, flexible exchange rates, etc.) make the US and China "strategic competitors" in a region where China can only grow in strength and influence while American strategic power wanes.

Australia's strategic dilemma

Consequently, Dr Lee suggests that Australia will never be a true friend of China, so long as "Australia retains its 'special relationship' with America". By implication, Australia needs to decide whether to align itself with the US or with China, gearing its economic and strategic policies accordingly.

Financial commentator Robert Gottliebsen, when analysing the attempted Chinalco takeover of Rio Tinto, suggested that "in a decade or two [China] may emerge as our 'protector' because they need to safeguard their raw material supply lines and because the US appears to be in decline". (Business Spectator, March 16, 2009).

Dr Ian Harper, a director of Access Economics and emeritus professor at the Melbourne University Business School, says that Australia needs to decide on its attitude to Chinese foreign investment as our economy becomes "increasingly oriented" towards China and Asia.

Speaking to a Menzies Research Centre round table on the big issues facing Australia (Big Ideas, ABC Radio National, March 25, 2010), he said that our traditional foreign investors had purely commercial interests that broadly coincided with Australia's national interest. That was now changing.

The crippling effect of the global financial crisis and the tighter regulation of international financial institutions were now making it more difficult and more expensive to borrow from our traditional lenders in the US and Europe. Consequently, Dr Harper warned, it was highly likely that Australia will have to rely more on foreign direct investment from China and, by implication, on Chinese ownership of our resources industries.

Although it's off a low base, the rate of growth of Chinese investment will remain high well into the future.

Dr Harper asked: how do we manage this, given that Chinese companies are heavily involved with the state, which considers commercial and political interests at the same time?

The "national interest" was not defined in the Foreign Acquisitions and Takeovers Act written in the 1970s, but now Australians will have to decide what is their national interest, he said.

This raises a major strategic question for Australia: if the nation's banks cannot continue to borrow from Europe and the US to keep funding the insatiable appetite Australian consumers have for debt, will the banks have to rely more on borrowing from China?

Australia's private sector net foreign liabilities are now $769 billion. To this must be considered an expected $400 billion in the total debt of federal and state governments and public corporations by 2014. How is this debt to be financed?

Ashok Jacob, CEO of James Packer's Consolidated Press Holdings, told a Macquarie Group conference last year that "Australia has the most leveraged banking system in the world ... $900 billion in deposits, $1.5 trillion in loans. A shortfall of $600 billion [roughly equivalent to the net foreign debt] is going to be rolled over by the major banks over the next four years, which leads to a lot of pressure on the system." (Australian Financial Review, June 18, 2009).

Australia's banks have been lending for long periods using short-term borrowing from overseas. Australia needs to act now, before a second global financial crisis or a China-led slowdown precipitates the sort of worrying scenario envisaged by one of the world's leading investors, Warren Buffett.

Buffett has pointedly observed that the world is witnessing a new form of strategic dominance. Countries that excessively depend on foreign borrowing risk losing their sovereignty, being "colonised by purchase rather than conquest". (Fortune, October 26, 2003).

Preserving Australia's economic sovereignty

Clearly Buffett's warning means that if Australia wants to safely preserve its economic independence, it needs to radically reduce its addiction to foreign capital, particularly from authoritarian countries like China.

Greater self-reliance in capital needs would allow Australia to trade with China and other nations, but on our terms - not on theirs.

a) A sovereign wealth fund

Recently, leading financial economist Saul Eslake argued for the establishment of an Australian sovereign wealth fund. In a paper, Fit for the future: Challenges for the next generation of Australians for the Institute of Chartered Accountants (April 2010), Eslake said the fund was needed first "as a means of ensuring that future generations derived at least some benefit from the sale of Australian resources to China, India and other countries".

Second, it would "help to ameliorate public disquiet about equity investment in Australian resources projects by foreign state-owned enterprises or sovereign wealth funds, either by taking stakes in overseas enterprises or even (under clear and rigorous guidelines) taking stakes in Australian resource projects".

He said that it could be funded from "newly introduced resource-related taxes, or from future budget surpluses", following the example of other commodity-exporting states like Norway, Alaska, Newfoundland, Chile, Malaysia, Brunei and many oil-exporting nations.

He suggested that the fund could be administered by the Commonwealth Government's future fund, which was established by former Treasurer Peter Costello.

b) A government-backed bank

Last year, six leading economists suggested that the federal government establish a "a publicly-owned entity to offer essential services in Australia's finance sector" to, in effect, offer Australians a more secure, government-backed bank in the wake of the global financial crisis.

The economists included Joshua Gans, professor of management at the Melbourne University Business School, Nicholas Gruen, Christopher Joye, Stephen King, John Quiggin and Sam Wylie. (The Age, July 8, 2009; News Weekly, July 25, 2009).

They argued that this new bank was needed because of the risks posed to Australia from its "large foreign debt that has continually increased its liabilities via enormous current account deficits ...".

Indeed, either the Commonwealth future fund could be tweaked into such a bank, or a separate bank could be a conduit for this purpose.

Arguably, such a bank is needed for wider purposes:

• to provide Australians with a more secure savings and investment institution, as argued by the six economists above;

• to channel funds into sectors of the economy strategically important for maintaining Australia economic independence, ensuring Australian ownership of these sectors; and

• for badly needed infrastructure development.

Much has been said about having infrastructure projects funded by superannuation funds, which now manage over $1,100 billion in investments. In reality, super funds do not have the expertise to manage infrastructure investments.

Rather, a development bank is a far more sensible conduit for funds from the superannuation industry into new infrastructure projects.

Such an institution would also provide other advantages to government. It would give valuable insight into the operation of the banking sector at a time when new regulatory measures are being considered worldwide, and provide an alternative means of ensuring credit in the event of another major global financial crisis.

Many other nations have set up successful, broad-based development banks, such as Germany's famous Kreditanstalt für Wiederaufbau (KfW), established in 1948, and New Zealand's highly successful Kiwibank, established in 2002.

c) Defining "the national interest"

The foreign investment rules need rewriting to limit investments from foreign sovereign wealth funds and foreign-owned/influenced government corporations, and to ensure that such investments do not cumulatively lead to the takeover of strategic sectors of the economy, compromising Australia's economic independence.

This requires detailed examination, a process begun in recent federal inquiries into foreign investment, followed by a major public debate on the issue.

However, no matter how restrictive the foreign investment rules are made, they will not protect Australia's economic sovereignty if the nation continues to become increasingly dependent on foreign borrowing from China to pay for imported manufactured goods and food products that we no longer produce, and on foreign direct investment from China for the development of our minerals and energy industries.

Hence the need for an Australian sovereign wealth fund, a government-backed development bank, and a substantial and sustained industry policy.

d) Industry policy

Policy-makers, as well as finding ways to reduce our dependence on foreign borrowing, need to do more than fatalistically resign themselves to the loss of our manufacturing and agricultural industries because of the growing problem of Australia's two-speed economy.

Typically, economists argue that manufacturing industries will need investment and innovation assistance to increase their productivity and survive.

However, even this won't save these industries from destruction if there is a protracted resources boom causing a sustained high-valued Australian dollar. They provide no solution to the major market failure cause by a two-speed economy.

Governments will have to consider specific industry policies aimed at keeping these industries alive until the resource boom subsides.

Consider Australia's well-developed motor vehicle industry, which is under imminent threat. This industry has many domestic, interdependent supply companies. It will take more government intervention than just subsidy handouts and tax concessions for research and development to keep this broad-based, high-employment industry alive.

Consider agriculture, where, according to long-term trend figures from the Australian Bureau of Agricultural and Resource Economics (ABARE), the average farmer's net income will hit zero between 2015 and 2017 ("Impending collapse of Australian agriculture", News Weekly, May 16, 2009).

If agricultural industries are to survive, there needs to be a major review of National Competition Policy, trade and water-trading policies. The decline in agricultural industries will leave our nation significantly dependent on food imports.

e) Energy policy

Australia's foreign debt is set to blow out even more by 2015 as the nation goes from supplying 80 per cent of its own liquid fuel needs in the 1990s, to being 80 per cent reliant on imports by 2015.

To this end, Australia should be investing in the greater use of gas in cars, a major biofuels industry (particularly ethanol from the nation's large but faltering sugar-cane industry) and coal-to-oil conversion from the nation's huge coal resources.

Conclusion

From the time of British settlement, Australia's strategic and economic interests have coincided. Now they are increasingly in conflict, while the nation's political leaders remain lulled into a dangerous complacency by the Lucky Country's 222 years of good fortune.

It is now urgent that Australian politicians begin addressing the new economic and strategic realities that will challenge the democratic and human rights values of Australians, and this nation's sovereignty.